A Wall Street Journal (WSJ) article from early 2015 begins with a quote by legendary baseball manager Casey Stengel, who said: “Can’t anybody here play this game.” Stengel was referring to the hapless 1962 New York Mets but the WSJ article noted that this lament was also applicable to stock-fund managers. The Mets finished the 1962 season with a 40-120 record, only a 25% winning percentage, but this beat the measly 13% of stock fund managers who beat their index benchmarks in 2014, according to the WSJ. The U.S. stock market had a solid year in 2014, with the S&P 500 Index increasing by 13.7%, but actively managed stock funds only rose on average by 10.2%.
Why do investors stick with mutual funds? Probably because most do not evaluate the index comparisons, and others are stuck in 401k plans with no alternative options. After all, investors in stock mutual funds still enjoyed a 10% gain in 2014, what’s to complain about? But ignoring the differences means leaving significant “money on the table” year-after-year that on a compounded basis leads to a major deficiency in account value. For example, a $100,000 investment that returns 10% per year is worth $259,000 after 10 years, but $310,000 at a 12% return.
The often asked question is why an investor can’t select among the 10%-20% of funds that do outperform. Picking prior years’ winners seems like a good strategy but research continually shows that it does not work. For example, a recent study by S&P Dow Jones concluded that only 10% of top performing mutual funds in September 2012 remained in the top quartile of funds in September 2014. This means that 90% of top funds in 2012 could not maintain their leading status only two years later. When stretched to 5-10 year periods the statistics look even worse, with only about 5% of funds managing to maintain top rankings over this period of time – no better than random.
As part of our analysis we took a quick look at the largest actively managed stock mutual fund, the Fidelity Contrafund, with $106 billion in assets. This fund is highly touted seemingly for good reason: over the last 10 years the fund has outperformed its benchmark by about 2% annualized. But examining a bit closer at the numbers shows that Contrafund’s fate is similar to other top funds that fail to maintain their leading position. The Contrafund’s 10 year results are entirely based on strong years in 2005 and 2007. But in the seven years since then the Contrafund has lagged it’s index benchmark: in the last five years by 0.6% points per year, in the last three years by 0.9% per year, and in 2014 by more than 4% (and even below the 10.2% return of the average stock fund in 2014).
Since the statistics are clear regarding stock mutual funds why do many of the large wealth management firms place clients in these investments? The reason is that these firms earn fees directly from the mutual fund companies for placing client assets in these funds, but do not receive similar compensation from index funds. This framework creates obvious incentives for wealth management firms to direct client assets into funds that pay higher fees. This conflict of interest can go unnoticed since the fees are not necessarily directly deducted from client accounts. (In fact, some firms tout that they do not charge clients any fees, but of course it all comes out of the mutual fund fees which eventually flows back to the wealth management firm). Note that these activities are perfectly legal and fully disclosed by the wealth management firms. They remarkably even disclose to clients that they specifically will not offer mutual funds that have not agreed to pay the wealth management firm a fee – meaning that advisors are limiting their choices based on fees, not on which funds are best performing. Here is the specific language from one leading wealth management firm (name omitted):
“FIRM XYZ makes available to its clients shares of those mutual funds whose affiliates have entered into contractual arrangements with FIRM XYZ that generally include the payment of one or more of the fees described below [various type of sales and service fees]. Funds that do not enter into these arrangements with FIRM XYZ are generally not offered to clients.” [DIA’s italics]
Mutual fund companies also disclose these relationships and even highlight the conflict of interest, such as this example in one fund’s literature: “If you purchase shares of the Funds through a broker-dealer or other financial intermediary, the Funds and their related companies may pay the intermediary for the sale of Fund shares and related services. These payments may create a conflict of interest by influencing the broker-dealer or other intermediary and your salesperson to recommend a Fund over another investment.” [DIA’s italics]
Although index funds are growing in assets they still comprise only 1/3 of total stock mutual fund assets. There is still $7 trillion sitting in stock mutual funds, 95% of which will underperform their benchmarks over the long run. These assets generate billions of dollars in fees and support numerous magazines, websites, newsletters, and wealth management. Instead of sifting through mutual funds, investors should focus on portfolio allocation, select among six to eight stock index funds that fit their investment profile, develop a fixed income investment plan, and rebalance the portfolio periodically.
On another matter, DIA is pleased to announce that the firm has been interviewed and quoted in an article in the February 2015 issue of “Kiplinger’s Investing for Income” newsletter about the benefits of fixed-to-floating rate preferred stock.